Guest Post: An Austrian View On High Frequency Trading

In our last letter, we made some comments on high-frequency trading. Today, we want to briefly analyse, from a macroeconomic perspective, the underlying ideas thrown in its favour, as well as the impact this activity has on the capital markets. Why is this important? Because more than half of the trading volume in equities in the main world exchanges is driven high-frequency trades today (More than 70% of volume in the US exchanges alone).

What is high-frequency trading? We will never exhaustively address this issue here. We recommend that you do your own research on the subject. There are numerous articles on this topic. High-frequency trading (HFT) consists in using sophisticated technology to trade securities. It is highly quantitative, employing algorithms to analyze incoming market data. HF investment positions are held only very briefly, with HF traders trading in and out of positions intraday tens of thousands of times. The important feature is that at the end of a trading day there is no net investment position. Processing speed and access to the exchanges are critical.

HFT strategies can be broadly thought in terms of three main groups: Those that provide liquidity, those that trade headlines and those that trade statistics. The statistical ones are the easiest to understand (at least for us): They are based on technical analysis, correlations. The headline strategies seek to profit from momentum trading, filtering information that describes intra-day action in the exchanges. The so-called liquidity strategies are either based on market making (to profit from bid/ask spreads) or from rebate trading. Operationally, HF traders collectively send millions of orders, the most part of which (we understand above 90%) are cancelled before they are even hit. This often causes delays in the exchanges that receive them, potentially creating arbitrage opportunities in those stocks that trade in multiple exchanges.

Two main factors have been put forward in support of HFT. We will quickly dismiss them:

a) HFT provides liquidity to markets

We think this point has been misunderstood, because at a macro level, one must not refer to the liquidity of a particular asset, but of liquidity in general or, more properly, liquidity preference, since liquidity is not a condition intrinsic to any asset, but the result of preference by market participants.

Indeed, HFT may and does provide liquidity to a particular asset, but it is a different thing to say that HFT provides liquidity to the market, at an aggregate level. At an aggregate level, the liquidity preference of market participants is what matters. If they want to be liquid, they have the means to do so either by holding money or by changing it for commercial paper or short-term obligations of borrowers with a solid and steady cash-flow stream. Collectively, for market participants to allocate some of its savings to liquid assets, there is no need to see millions of quotes a day, for instance, on a risky junior mining company with assets overseas, thereby creating the illusion that the junior mining equity space is liquid.

Market participants do not need to see the universe of liquid assets expanded to satisfy their respective liquidity preferences. And if they have to get their savings out of an asset which until a minute ago seemed liquid but now is not, they will be able to do that with or without HFT, because there is no reason to believe that under a shock, the HFT bid will not disappear in a nanosecond, making the situation even worse.

Having said this, it is clear that the impact of the quoting activity by HF traders generates a distortion in the capital markets and particularly, in the capital structure of an economic system. Companies that, given the nature of their businesses, would have been forced to raise secured long-term bank debt to fund their capital expenses before the influence of HFT, may now find it easier and cheaper to raise equity. And those with investable assets captive in the system (i.e. registered funds, 401ks) will now fall prey to very risky projects, under the belief that they are protected by electronic stop-loss orders. Banks that might have been willing to provide secured lending to these equity issuers, will now find that they can only bid for less profitable working capital lines, under the belief the loans are protected by stock pledges! And it gets even worse: Those who invest in this equity may decide to pledge it under, say a 3x coverage ratio, to borrow funds and invest in even riskier, “more profitable” assets!

The liquidity argument in favour of HFT is just one more Keynesian version of the notion that inventing purchasing power ex-nihilo can get us somewhere better, but this time, applied to the capital markets in particular.

How does HFT invent purchasing power? The liquidity premium embedded in assets that wouldn’t otherwise be liquid or would not even exist, is the purchasing power we refer to. For this same reason, those who defend HFT now fear that by prohibiting it (just like their fear to prohibit fractional reserve lending) we will see a collapse in valuations. Unfortunately, that collapse will eventually take place, only still bigger and affecting global capital markets.

b) HFT facilitates the process of price discovery

What media and those in favour of HFT commonly refer to price discovery is nothing else but algorithms sniffing stop losses, causing volatility in the process. There really isn’t anything particular about HFT with respect to pricing, which human beings cannot achieve on their own. Throwing orders to exchanges that are immediately cancelled to test floors or caps on the price of a certain asset cannot be credited with price discovering. Indeed, efficient markets are those which always challenge valuations and in the process, prevent the misallocation of resources from further growing. But the challenge of valuations always represents the challenge of their underlying assumptions: Sales, leverage, productivity, management, etc. Shaking the nest, the way HFT does (with the sudden introduction of millions of quotes) to “discover” key levels is hardly the feature of a healthy capital market.

Let us bring an analogy: Human lives are not traded. Yet, if a criminal kidnapped somebody’s daughter and asked for a ransom, he would certainly be “discovering” the price of her life: The parents of the girl, having offered all they had in immediate liquid assets, would have told the criminal what the price for their daughter is. Now, this is exactly what algorithms do when testing price levels in the absence of economic news, as we have painfully seen across a myriad of asset classes.

This is not a healthy way to price assets, because just like the parents had never thought of trading her daughter for money, market participants not challenged by economic developments but by millions of fake orders, were forced to do so. A trade actually took place in an otherwise illiquid market but…what will happen next time? Neither the daughter will be left alone by the parents nor our market participants will be there for the criminals to profit from them, which is why retail money will keep flowing out of the stock exchanges (the system) as long as the status-quo is not changed.

Perhaps too, our fictional criminal will regret not having given the father more time to liquidate more assets, but of course, that would have come at the cost of higher risk. There is no difference between the criminal’s short-term line of reasoning and that which keeps HF traders from keeping positions for longer than seconds or minutes. Therefore, if we were really thinking about price discovery, neither our criminal nor HF traders did discover the true price. In the end, all we ended up with was volatility that will exponentially increase, as the exchanges impacted by HFT see participants leave to over-the-counter markets (like real estate?)…Is this the actual reason behind the high percentage of HFT volume in exchanges? Is it because we are leaving the exchanges all to HF traders?

The market crashes driven by HFT, like that on the NYSE in May 2010 or the recent one affecting the Knight Capital Group should be a big wake-up call. This is a new technological change which the Austrian School of Economics should further analyse. We, at “A View from the Trenches”, just wanted to leave our two-cent contribution with our thoughts. We leave with an interview on the subject, to Scott Patterson, author of “Dark Pools”, dated August 8th

Especially interesting: HFT's effect of capital market distortion toward equity, and the mispricing of said equity due to the fake liquidity premium (and in the case of manipulative algos outright fixed prices, one might add).

HFT just fits so naturally in with TPTB. Desperately the financial wizards are trying to dream up yet more byzantine ways to keep cooking the books, to keep kicking the can down the road, to delay the inevitable asset price correction to *true* market value.

I'm all for HFT. I'm a busy man - why should I have to wait months or years for Wall Street to screw me out of my retirement money the old fashioned way? I want to take advantage of the miracle of modern technology and be wiped out in mere nanoseconds.

To be fair, the greater destroyer of price discovery, and possibly causing a greater distortion in prices, is the forcefeeding of billions of dollars into the sharemarket as governments round the world copied the Chilean model of pension saving. This was of course a bonanza for those already with shares, or those working in financial services as there suddenly were fees galore. By law, a huge amount of cash was forced into shares, not specific shares but just the entire market. All this of course compounded by the usual villains of leverage and speculation.

Barron's DC pro Jim McTague writes a piece suggesting a change to slow down HFT in this weekend's edition. He confirms that the various exchanges DO rent out coveted space at their server farms to others who want to be there VERY close to the exchages' own servers (similar to what I have read here at ZH). Apparently many of these very fast trade trades can be done in less than a millisecond, McTague looks with favor on slowing this down to 10 milliseconds.

HFT is risk avoidance, a kind of perverted anit-investment Frankenstein.

It works against price discovery and liquidity to make momentary gains by jiggering both.

It is no wonder that it causes flash crashes as the battle is to make money from nothing rather than to invest.

Combined with humans who are unnacountable to the rule of law, both taking advantage of those who are trying to make real life decisions to save and invest their blood, sweat, and tears, HFT is an intestinal parasite - a pox on society.

imo algo HFT is simply the computerized result of the bid-ask spread going human-less as specialists left their traditional "posts" and "market-makers & liquidity providers" came on

the money isn't made "from nothing" it is made from the spread!

so, on a micro-level, the ability to move the spread with hi-freq agility became a cash cow and we saw mo&moCowbell

and the ability to "attack & beat the spread" [use it to your own trading advantage] became a nano-science as the algo-writers studied the market makers and liquidity providers for HFT weaknesses

the central issue (again, just my opinion) is the "orderly market" rubric, which is why the specialists left in the first place: they could not "fade" the M&A craze profitably and the costs/risks of maintaining "order among thieves" grew with every credit-bubble the banksters generated to buy assets [think GE under walsh, the LTCM blow-up, and the subsequent repeal of glass/steag. & the creation of thye TBTFs by TPTB, by which they took over america, politically and (mittens OR Prez0) surely intend to keep it]

the fascistas will get their peons to work on the boilerplate and "fix" things. again

so perhaps people will begin to see the baseline fallacy: that boilerplate can "fix" things

it can't; slewienomics indicates it is always just:

boilerplate hubrisn-1 + MSM propaganda = "fixed! trust us!"

and yes, it is global & globalism and it rules by moving the goal posts by boilerplate "legislation & regulatory powers"

btw, lauren was just up in vancouver and she published a buncha vids working w/ agoraPublishing (bonner& wiggins)

boilerplate determines the "power of the files" (maxWeber); read what they send you for your bank acct, brokerage, options/ index options trading ok, even your phone and utility bills or your lease or rental agreement

that is boilerplate; it is what the smiling attractive friendly marketing rep gives you for your money

it is free-market capitalism, socialism, communism, the US and the EU and canada and the WT0, the UN and the cable company too; airline maintenance and teamster rest for drivers who would rather just push for home; it is republicanism and democratism and teaPartyism---they all want to control the fuking boilerplate with their "marketing"

then we all pretend TPTB understand and we watch TV for clues they have intelligence or pray that our religous leadership can guide us, too, into trusting the pols b/c that would be "god's will" b/c they are "in authority" and "enforce the boilerplate" even in pre-schools

HFT is merely a form of boilerplateHouseRules

go back and re-read the comments substituting "boilerplate" where appropriate... see ya, BiCheZ!

Interesting echo: in the film Limitless, about a man called Eddie Mora who becomes a ubermensch through taking a drug that gives him 100 percent access to all his brain power, Eddie appears to makes his fortune through inventing a process/mechanism somewhat like HFT. If you listen to the dialogue in the scene with him and Van Loon (De Niro), there is some mention of microscopic market processes that shave out pennies through tiny stock fluctuations.

I think this is kinda interesting as the film ties a thread from HFT antics to Master of the Universe-dom to political power to a state of almost human divinity. Makes me wonder if that film gives a reasonable representation of how the Squids actually think and see the world.

Operationally, HF traders collectively send millions of orders, the most part of which (we understand above 90%) are cancelled before they are even hit.

So it TOTALY is illegal. You cannot put in a bid that you have no intention of making. That is called market manipulation, and the SEC should therefore shut down HFT just on that basis alone, regardless of the "benefits" or "negative effects". You simply cannot "do" this in a market, it is not within the rules.

By the end result. The needs no "intention", all that has to happen as is stated on this forum many times:

MAKE THEM TAKE THE BID AND NO "DO-OVERS", they are stuck with their buy and sell orders. HFT's put in a bid, that bid is made, and a 2 second rule would be good as well. Ther is NO reason onther than swindeling for the issue of trades of "milliseconds.

Everyman, you are bang on. Forget all other arguments about whether HFTs are good or bad. I think they call this "spoofing" and the regulators go after normal traders for this. Why not HFTs? Or they could implement a rule that says the algos can't spoof. They could do this tomorrow, but of course won't. Can't jeopardize "liquidity", LOL.

Wall Street can pretend HFT alone is a money maker or that it is some awesome tool. But it is neither. It is a loser. It only works in conjunction with some other sort of fraud or arbitage. If everyone is using HFT, there is no arbitrage. So unless you are in on the fraud, HFT is just a loser when you are straight trading with it.

HFT blow ups have been common with flash crashes and smashes. They build up huge positions pushing around illiquid issues and then they try to get out and "boom". But until knight, they cancelled trades and let the HFTs off the hook. Knight is an example of what HFT really does to people who try to use it without the buddy system.

As long as we no longer cancel algo trade mistakes, HFT populatity will die. It will only be used by bigger firms as a loss leader pushing the market around to make their options trades go in the money.

Indeed. Mises masterpiece Human Action, quickly dismisses retrospectively any notion that the price discovery of Skynet is somehow a fine paradigm of the spontaneous order of dynamic markets.

Critics of the Austrian Perspective of the Economic Calculation problem, cite information technology as the new source of evaluating scarcity by quantity and providing the means of centrally planning resource alllocation. However no IT system no matter how advanced could possibly deal with desirability of humans and the subjective theory of value. As individuals we have subjective preference scales with infinite combinations collectively, which can never be derived except through the mechanisms of the market place where we all participate.

Problem is not in HFT, its just a set of technical routines which are currently available. Why it is used as it is? Answer to that goes beyond very selective Austrian criticism. You cannot have your cake and eat it too. Its civilizational insanity to which Calimero Austrians are blind.

Luddites were against Capital Investment. Savings and Investings are paramount fundamentals in Austrian Economics. Better and faster capital goods are the integral force behind advancement in civilisation. But these machines do not replace the market mechanism, they simply increase the standard of living.

HFTs are trying to replicate price discovery which can only be performed by humans. HFTs are just another form of bureaucratic central planning that crippled communist and socilaist nations for the past century.

she understands that to have human fiduciary responsibility is to have human markets

and you get it too b/c at the same time, rules will never be so perfect "that humans no longer hafta be good" so the lack of enforcement actually now rules finance; flee! flee!

however the idea that "debt is money" and fiat-creating banksters and their fascista minions have "first crack w/ the new digits" tend to push the "responsible fiduciary" envelope into a rope-a-dope of MOPE where we hope the slope don't toboggan past our screaming ability to cope w/out a borgia pope may be the "base fallacy"

which is why i fight for PMs becoming re-established as legal tender (alongside fiat for now) so the public interface and tax-consequences of human economics are no longer determined solely by fiat banksters preaching "democracy and freedom for our valued debt-slaves" from the temples0'Doom while they subjugate every other form of human individual and collective enterprise to d.e.b.t.INC and bar the exits from d.e.b.t., politically/legally via boilerPlateHouseRules a.k.a. "legal tender laws"

fuking bullshit on a stick won't do this year... let's use waffle cones!

The problems with the markets are due to failed Socialist interventionism ! I believe freedom is capable of discovering and dealing with all realities .... and a good dose of freedom's elixir is what is needed here and everywhere ! Monedas 1929 Commodity Jihad World Tour

As a software engineer with market insights, I suspect that the quick algo swings up and down (and sometimes as shown at ZH before (http://www.zerohedge.com/article/fractial-limit-order-buster-latest-mark...) as growing in amplitude) are designed to increase nervous tensions that result in people or other algo's to adjust their limit orders or stop loss orders on both stocks and options. The algo may probe then stand back for 5 to 30 minutes to watch for changes then probe again. After determining weakness or panic then the algo can swing in for the profits such as in a short covering period.. An algo like this could easily be used in situations where the bid ask spread is large so no trades would even likely result but the information gained by watching the changes to the bids, asks, and limits in the next few minutes could be analyzed for exploitation.

Another manipulation could be to alter the true bid/ask prices towards the direction you want a stock to move, even though no trades may have occurred. The wildly swinging prices on sweeping orders might allow a trading house to claim any value in the swept through price range as the bid and ask values even though there was never any intent for the HF trade order to execute. An algo could even report one bid/ask spread to someone positioned long and a different spread to someone positioned short, and both of those bid ask ranges may have been true in the previous second. Does anyone know if the bid/ask spreads for all customer inquiries (or data pumps or data feeds) has ever been examined to look for a customer by customer bias where short and long positions are given slightly different sets of data?

That's how I would design the logic.

Statistics could be kept and a trading algo could become very confident in the outcomes. If an algo has been run hundreds of thousands (or even millions) of times in the past and fine tuned from the knowledge gained, then it could easily recognize places for it to attempt to step in with a trading strategy that has proven itself as successful in similar scenarios in the past. Part of the quants jobs are to quantify statistically the success of algorithms tried out on the markets

HFT is natural progression the crony capitalism and lack of regulation/oversight is the problem. They let them do as they please because they are the volume. If they are predatory such as stepping ahead of resting limit orders by fractions of a cent, latency arbitrage or trading to move price they should be stopped. If they are only taking a valid legal nonpredatory strategey and automating it, that's okay. When they disrupt the entire market and expect to have the trades busted that is not okay. There is nothing wrong with an algo that wants to buy a million shares over the course of the day a piece at a time.

Wouldn't a tax on cancelled orders solve the problem? Trade goes through, no tax. Trade gets cancelled $0.01 tax. With 99% of orders getting cancelled I think a cancellation tax would be appropriate and no burdern on legitimate trading. That would take care of the problem without hurting legitimater markets.

link to the legislation, please? and if it depends on enforcement based on the "intent" of the algo can you please include that also?

not maxK, k?

no (yes?) it isn't price discovery; it is a computerized trading strategy and seems to be based on the "bid-ask spread" and the "stops" which are entered into or more impotantly around this spread

so it is a bid discovery and stop discovery & take-out service; you broker "enters your stops" (unless s/he fades them and keeps them in-house) so the HFT algos "perform a service" to the broker

in slewienomics:> "lo-volume" = retail stops taken out (broker pays rent and/or "arranges" the sales tickets for house gain)

this is the new whip, comrade debt-slave BiCheZ! snapping up a nice welt on a back near you

when your stops get "bid or asked" that isprice discovery or my middle name isn't "the"

these scams have been around in one form or another since god was a little girl and it is just the same old: he who is closer to the trading platform in space/time gets the trade crossed or the commission or both

so how to enter orders and set stops and/or hedges and why is pretty key to know and learn b/c once you get yer hedge in place, the stops can come down and you can just ride the trade for a while, riiight?

that is why derivatives are so sweet: you can set up hedges galore and never go near the underlying asset while "controlling" vast trainloads of same

i think this is how high fructose corn syrup took over our lives:> some shithead ended up with 400,000,000 tanker cars full of the paper version of the shit and offered the syrup makers an offer they couldn't refuse

limit orders simply say "i will pay $20/share and no more" and they can be made in different ways (till cancelled/ for the day; all-or-none)

tyler put up a piece or two here maybe a year ago [nanex] showing how some market (not limit) order got "HiFreakShopped" with scores of little "fills" at crazily-different prices and amidst zeroHeads going heavily armed, drunk, and hornily ape-shit, i just pointed out that with "limit of $20" or whatever it was there woulda been no "fills" above $20

BUT the order doesn't always get filled especially if it is an "exciting day" and the price goes to $20.25 and never comes back to $20 so you hafta know the spread and have a feel for how fast & far the spread is moving and whether liquidity might be a factor (depending on the specific play)

whaever can go wrong... will

you miss the spread, you ai'nt gonna trade; a market order gets filled (but at mr market's price, not mr_nufio's, not slewie's); but generally, you hit the spread with a limit order you're gonna get filled unless the market is extremely thin & you also need to give the market maker what s/he wants and not move the spread on yer own ass

so there is no "perfect" way and it is an expensive school around those succulent fringes, too

i'm old enuf to have been somewhat active the first time 'gold went to $1000 and silver hit $50' and the "markets" were pretty freaking crazee when theHuntBros(wildcatters) took on rockefeller (standardOil & chaseManhat) but that's another story; here, it takes us into a political time which if i understand it correctly indicates that nothing has changed up till today really

crooks bullshit and lies + political cover = they "fixed" nixon/kissinger/rocky and now we get 'him' by voting for either party! register now! "nixon" can never be caught and removed again! they fixed fuking nixon!

this weed is really good btw; anyhow, this ZIRP is really no fuking crazier than when these bozos had to crank the prime rate uip to 18% less than a decade after they "abrogated the int'l gold standard" instituted before anyone but the MIC had even conceived of the MIC

the NW0 = nixonian democracy

they have out-organized and boiler-plated everyone and now people are noticing the IOUs to fund the universities too! nonetheless i hereby demand their immediate and unconditional surrender to zH

and it's a good thing they built thoseFEMA thingies for themselves, too!

That's like saying Democrats are for free air and no meteor impacts. Republicans are for not drying up the oceans and anti-supernova.

HFT is not an economic ideological issue. It's an issue of allowing the introduction of fraudulent, market breaking elements and calling them legitimatee and looking the other way. Not to mention, the continuance, and escalation of them.

Ps. This data is a year old and Allianz frustration of having seen Pimcos' Gross and El-Erian pay themselves approx. $400ml between the two annually while Fink as an independent pulls down $25ml... pisses them off!

there is no reason to believe that under a shock, the HFT bid will not disappear in a nanosecond, making the situation even worse.

This is critical and key to the whole mess. It’s basically saying correctly that volume is not liquidity. You only truly have liquidity when you have a wide variety of participants active and influential in the market for different reasons. In contrast, when one HFT algo ultimately dominates the market, then by definition there is only one participant in the market for one reason, effectively trading against itself. Unless the HFT algo employs a fair market making protocol, it is anti-liquidity by design, existing only to scalp and extract margin from other market participants until they get frustrated and leave.

This is what I find Austrian about the perspective: The concept of liquidity vs. how it has been seen until now with respect to HFT (see Hazlitt for instance, on liquidity), the observation on the distortion of the capital structure (a typical point on relative prices distorsions and the importance of the price system to allocate resources), the challenge of the idea of price discovery behind HFT. These are all Austrian points that mainstream economics never acknowledges.

On the other hand, to quote Walras as Austrian (in the link you provided) is quite a stretch, don't you think? Since when did Austrians believe in the notion of general equilibrium???

On the other hand, that same post at Mises.org you referred us to acknowledges that: "these submitted quotations are meant to provide false information to other algorithms so as to confuse them, or to gather information from reacting algorithms so as to take advantage of them. By gleaning tidbits about their competitors, or providing them with false knowledge, algorithms and those who deploy them hope to gain for themselves a favorable spot in the bid-ask spread..."

Tell me, tell us...how can the Austrian school ever be in favour of filling the markets with false price signals that create volatility? No other school is as concerned about the health, freedom and transparency in the pricing mechanism than the Austrian...and yet, your referred article claims that Menger, if alive, would have been in favour of this clogging by fake quotes???? Really??? Please!